A Closer Look at How Private Equity Firms Operate: Securing Capital for Your Startup

capital

As a fledgling company, trying to find the capital to fund your startup can undoubtedly be incredibly daunting. Trying to balance all of the different considerations that play into its success, in addition to staying afloat, is admittedly a unique challenge not many will ever have to face. However, to private equity firms, your up-and-coming business just may very well be their next major project. 

While the concept of a private equity acquisition process can initially seem daunting — especially to the novice small business owner who may have just received a proposal from such a company — it’s also surprisingly formulaic. Getting backed by a reputable private equity firm can be the first step in not only becoming a resounding success, but also an opportunity to witness firsthand how these firms can transform an unlisted business into a highly profitable investment.

What is a Private Equity Firm?

Before understanding how the process of attaining backing from a private equity firm unfolds, it’s important to first recognize exactly what is a private equity firm and better know how they operate. A private equity firm definition is, in brief, a team of institutional investors who purchase shares in a business to gain a handsome return on investment (ROI). From aerospace and defense private equity firms, to those that invest in internet startups, the process is largely similar across the board.

Rather than actually managing a company, however, they instead act as a source of investment capital, oftentimes taking greater than a 50% stake in the company’s shares. It’s important to remember that Private Equity firms like Teoh Capital don’t usually invest in publicly traded companies. Generally speaking, public companies are subject to greater regulatory scrutiny than private companies, which can make the acquisition process more complicated. Instead, they either only focus on private businesses, or they actively delist public companies in order to privatize them.

How do Private Equity Firms Work?

There are a few different considerations that come into play when it comes to how a private equity firm decides to choose a business to invest in. How do private equity companies work, and what exactly are these important criteria? First, they need to find a company that shows significant potential for growth. Typically, these companies must have several years of history backing them, demonstrating their ability to become profitable.

After thoroughly researching these private equity leads to make sure they won’t wind up as a dead-end, these private equity investors will then turn their focus on drumming up the capital to generate the funds necessary to invest. To do this, they will consult with a limited number of partners to gauge their interest and secure the funding. When they have enough capital, they’ll then close the fund and turn around and invest it into a promising company. 

As far as investing in a company, one popular method to do so is by initiating a leveraged buyout (LBO), which is one of the more common (albeit somewhat hostile) methods of investing in a company. That is, they’ll purchase a majority share in the company by securing both a high amount of equity and debt from them, which will eventually be repaid by the said company. In exchange, the equity firm will then endeavor to help bolster the company’s profitability, making it a win-win for both parties.

What are the types of businesses private equity firms invest in?

While it may seem as though the type of companies that these private equity firms invest in is somewhat random, there is actually a fairly methodical process as to how a private equity firm works. What do private equity firms look for in companies? While there’s no hard and fast rule as to what they tend to look for before selecting a business to invest in, there are a few things they are mindful of before pulling the trigger on an investment. 

However, the company’s revenue ranks high on their considerations before they decide to move forward on an investment. Also, depending on their own vested interests, they may focus primarily on companies that may be located in a particular geographic location, or they may select those that are in a specific industry that also happens to show strong growth potential. Private equity firms tend to employ people with incredible real estate skills as well, so many of their holdings end up being properties. 

What do private equity firms look for in businesses?

To land on a private equity firm’s radar, there are a few criteria that first be met. For instance, a company needs to have a positive cash flow, be self-sufficient, possess a minimum of $3 million in EBITDA (earnings before interest, taxes, depreciation, and amortization), and have both a strong market position and an equally strong exit strategy. Without these things, the risk to the private equity firm can be too great, and it would not be considered a viable or worthy investment to them. 

Market Position

One example of private equity companies’ strict attention to detail before moving forward with an investment is how careful they are in educating themselves about the targeted company’s market position. Indeed, before a private equity firm can consider a business for an LBO, they first must verify that the company does hold a competitive market position. Furthermore, it also must demonstrate a strong potential for growth, as a stagnant company is also one that will not reveal a profit in the years to come. 

Management Team

A private equity firm will also want to make sure that any company they invest in has a strong existing management team in place. A flimsy organizational structure can quickly spell failure, which is precisely why they are so exacting in this criteria. This team will ideally know how to run the company for the private equity firm, allowing them to stay somewhat hands-off while still monitoring their investment.

Not only should this management team be able to prove an ability to pivot under stress, though, but they also need to be able to demonstrate an ability to recognize profitable opportunities and rise above unexpected challenges. This is especially important, as these private equity firms would ideally like to keep the existing managerial team in place, rather than have to undergo the costly process of hiring and training their replacements

Industry Trends

Adaptability is another key consideration that a private equity firm will weigh before deciding if they want to invest in a company. The company in question needs to be able to know how to leverage emerging industry trends, as this shows resilience and flexibility. They also need to be able to demonstrate aptitude with disruptive technology, proving themselves to be malleable and relevant in the face of market or societal upheaval.

Growth

The value of a company’s growth cannot be overstated, especially in terms of how a private equity firm regards it. That said, the potential for growth takes on a number of forms, and the private equity firm will be mindful of all possible manifestations of it. When inspecting a company they are considering, the firm will be careful to make sure they have a history of success, loyal customers, multiple channels for growth, and a positive market position.

Business Plan

A company also needs to have a business plan that demonstrates that it is not only ambitious, but it is also firmly grounded in reality. Without one, they will be of no interest to a private equity firm, as the risk of loss is far too high. A combination of clearly defined goals, in addition to the facts and figures supporting them, is imperative and non-negotiable to a private equity firm. 

Most private equity firms are acutely self-aware, and they know that not all of their ventures will be successful or profitable. Because of this, it’s vital for the actual successful ones to be resoundingly so. Being able to demonstrate an overall profitability of up to 25% or greater helps make up for losses in other investments, making a company all the more attractive to the private equity firm.

Exit Strategy

It’s been said that a private equity firm spends half of its time trying to figure out how to invest in a company, and the other half of the time trying to determine how it can eventually divest. That means that before they make a move on a company, they also already have their foot halfway out the door. A clearly defined exit strategy can help make this transition seamless, further reinforcing their intent to select a particular company for their LBO.

Security

An investment in a company is a highly risky one, and private equity firms are fully aware of this, even as they’re actively considering getting involved with it. The knowledge that they can lose everything looms over the entire process, and to help mitigate these fears, the private equity firm will generally require a modicum of reassurance. A little bit of security and influence, such as a seat on the company’s board and vetoing power, will go far in assuaging those anxieties and afford the private equity firm more confidence.

Contingency Plan

Nobody likes thinking about worst-case scenarios when facing a major investment, but the fact is, the probability of losing it all is nevertheless incredibly high. Planning ahead and anticipating these potential issues can help prepare the private equity firm for the very real possibility of things suddenly going south. While this awareness may not be able to prevent a disaster from occurring, the company should not only anticipate this likelihood, but they should also build in a contingency plan for it.

Reputation

Many startups have been born out of an entrepreneur’s garage, and it’s not uncommon for a business owner to want to hire their best friends to help them get it up and running. Unfortunately, should you decide to turn to a private equity firm for your capital, this can backfire and wind up harming your chances of doing so. Your team of managerial staff must have a rock-solid, squeaky-clean reputation, as you need to be able to demonstrate your reliability and trustworthiness to the private equity firm investing in you.

Cash Flows

For a company to grow, especially under the wing of a private equity firm, then it must also be prepared to spend money. Growth, in and of itself, does not automatically equate to profitability. Because of this, a company must be able to have several different avenues of cash flow (including sales, assets, and inventory) so they can pay off any accumulating interest. In addition, they must also have an eye on debts, such as overhead, staff and labor, and operating costs. This means ensuring they are fulfilling their contractual obligations and that their contracts are being paid as well. 

Low Capital Requirements

While it’s not outside of the scope of possibility that a private equity firm will invest a significant amount of capital into a company, this doesn’t mean that they’re going to be careless with their money. As a general rule, these private equity funds don’t want to continue to sink more and more capital into a business that doesn’t show the potential for solvency. Instead, they want to make sure the company will be viable after the initial investment, rather than needing several rounds of funding just to remain afloat.

Return On Investment

Ultimately, the goal of a private equity firm is to make a significant return on its initial investment. They’re not going in with the hopes of scraping by with a scant or meager profit. How do private equity firms make money? By smart in their investment, for starters, and employing strategic maneuvers in their selection process. Rather than trying to revive an inert company that has no chance of success, a private equity firm needs to be strategic in its moves. 

As their ROI is often tied in with the initial investment price, as well as the amount of effort required to help it succeed, weighing their options is vital. A company that has several other competitors inspecting it makes it all the more attractive to the investors. This can also help make sure the company will earn the private equity firm a tidy profit, too. Combined, these are all key considerations that these firms will weigh before making their move upon a potential company.

The Benefits of Private Equity Firms

Whether you’re the owner of a small business and you’re looking for a reliable source of capital to help boost your company’s chances for success, or you work for a private equity firm and you have your sights set on a promising company, it’s always important to perform your due diligence. Being careless, especially when discussing significant amounts of money changing hands, is dangerous for all parties involved.

As a business owner, you do need to be aware of the risks of relinquishing your company to a private equity firm. Conversely, as a member of a private equity firm, it’s especially important to vet a company and its board to help make sure you’re making a sound investment. The combination of fastidious research and sound strategic maneuvers can help ensure the transition from one owner to another is a resounding success for all parties involved.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.